Incubating the Most Viable Nest Eggs: Direct Private Equity Investing

The trend started several years ago. Spurred on by the astounding private valuations of companies like Facebook, Groupon, and Twitter, the idea of incubating startups took hold, and soon enough hundreds of “incubators” or “business accelerators” sprang up around the country. Today they are usually found near major universities or in big cities, or in regions where more mature tech or Internet businesses have taken root. While startup incubators have successfully enticed investors, in our view a more compelling opportunity can be found in lower to middle-market private equity.

The incubator concept theoretically makes sense: find a structure large enough to provide working space to 25-100 people and outfit it appropriately; offer amenities like high-speed Internet access, accounting help, legal advice, and unlimited espresso; then seed the promising start-ups with amounts ranging from $50,000 to $1 million. The collective innovating under a common roof presumably fosters the cross-pollination of ideas, from which all can ultimately benefit.

Family offices, many of them newly formed by patriarchs recently cashed out of businesses they had founded, were significant creators and backers of these incubators—and why not? It was certainly plausible that out of every 20 or 30 plans seeded one or two might prove itself and make the whole venture worthwhile. A single Pinterest or Zynga could justify a thousand seedlings.

Startup incubation, however, may be more appealing on paper than in practice. First, the distance between an interesting idea and a viable business is usually much farther than one can envision. The crucial step of finding actual customers is a constant business challenge. Beyond that, the expected synergies can take longer to materialize than anticipated. In addition, today’s tech entrepreneur is as comfortable working from his or her basement or bedroom as anywhere else, leaving some empty desks in the collective working space. Given these variables, the remaining incubators continue to operate under slightly less certain skies.

While the appeal of the incubator model may be fading for some investors, a solid opportunity lies at the opposite end of the business spectrum: direct investment in small- to medium-sized mature private companies.

The asset class is deep and wide, with over 146,000 companies in the privately owned middle market space, representing some $3 trillion in total revenues[1]. In 2014 alone, more middle market ($25M-$1B) private equity capital was raised than ever—$385 billion represented in over 1,700 deals—with exits also making the record books (over $95 billion of investments through 780 liquidity events)[2]. The impact is equally powerful on the economy, with the middle market providing over one-third (41 million) of private sector jobs in the US1.

The middle market opportunities will only grow as the baby boomers continue to age. Children and grandchildren show far less interest in carrying on family businesses than previous generations. Even when they want to assume responsibility, the dark cloud of estate taxation hangs overhead and complicates plans. In most instances, these businesses will need to be sold.

Unlike the startups discussed earlier, these businesses come with existing customers, many of the relationships built through decades of mutual loyalty. The ways and means that made them successful are well tested, their products and services vetted and value added.

Importantly, there often exists room for improvement post-acquisition. Aging owners may be less likely to pursue a fresh marketing campaign or to upgrade facilities. They may shy away from acquisitions that might offer profitable expansion opportunities. These scenarios create additional avenues to enhance the IRR of an investment.

Direct investment in small- to middle-market private equity transactions is not without its potential potholes—due diligence must be thorough. For example, the market for the company’s products may be limited. The loyalty of a customer base may fade under new ownership. The upgrades necessary to maintain the company’s competitive advantage may be more expensive than anticipated, and perhaps even uneconomic.

Most importantly, new ownership must have the appropriate operational expertise. As in any business at any stage of its life cycle, competent management makes the difference.

In a landscape with IRRs north of 20% widely available, what is the best approach for family offices and other institutional investors to leverage this sector of private equity? Given the premium on quality management, finding an operating partner with experience in a given industry or industry segment is a good first step. Then seek out businesses for sale in that industry or segment. Another approach is to find small private equity firms with expertise in such transactions. Often through their network they can solve, or have already solved, the operating partner challenge by negotiating the respective interests of a number of suitable CEOs or COOs.

Returns from traditional large PE funds in our view are in the process of leveling off at just above public equity returns, although arguably still with the advantage of choosing an optimal selling time. Large hedge funds, as noted in our last Family Office Alpha Report, are less risky but delivering mid-single-digit net returns. Venture capital has become more a game of successfully positioning for private shares in companies that in essence are well past the venture stage.

When executed properly, direct investment in private small- and mid-market equity acquisitions offers substantial opportunities for the kind of return profiles now elusive among other investment options.

[1]The Market that Moves America: Insights, Perspectives, and Opportunities for Middle Market Companies, GE Capital and The Ohio State University Fisher College of Business, 2011.